Designing effective incentive bonus programs

bonus programs

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Designing effective incentive bonus programs.

by Heiman, Frederick D.

Abstract- Well-planned bonus programs can contribute to a company's competitiveness by encouraging superior performance and, ultimately, improving the organization's earnings and cash flow. Typically a major co mponent of executive compensation programs, an annual incentive bonus scheme can also help firms attract and retain highly talented personnel. However, there are several issues that should be considered in the design and implementation of such a program. One of these is the considerable amount of corporate funds that will have to be spent to provide incentives attractive enough to motivate executives to improve their performance. Another consideration is the potential damage an ineffective program may do to the organization. Management should keep in mind that a successful program is one that has an internal control structure and a sensible upfront design, offers fair and reasonable individual bonus rewards, and is well-managed.

An effective incentive bonus program can have a positive impact on an entity's growth. An ineffective one can have the opposite effect. Advice on how to achieve the former and avoid the latter.

Intensified global competition has highlighted the importance of effective incentive compensation programs for U.S. companies. An annual incentive bonus program is a popular and effective form of incentive compensation, and is usually a key element in any company's executive compensation program.

A bonus program provides suitable rewards to motivate superior performance from the key people who impact profitability of the company. An effective program should maximize current profitability and assist management in attracting and retaining the best managerial talent. Achieving such an ambitious goal is not easy and can involve pitfalls which must be understood and considered in the design of the program and in its' administration. Providing suitable rewards to motivate superior performance usually requires the expenditure of a significant amount of corporate funds. If the program is properly designed and administered, it should have a major positive impact on earnings and cash flow. An ineffective program may have the reverse effect and severely damage the company.

As a factor in recruiting and retaining the best executives the program must be externally competitive and internally equitable. The program must be viewed from the perspective of the total executive compensation package, the details of which are outside the scope of this discussion.

The important elements to an effective program are--

* An effective internal control structure;

* Careful upfront design;

* Sensible and equitable individual bonus awards; and

* Proper administration.

Importance Of Internal Control Structure

Significant monetary rewards are necessary if the bonus program is going to motivate management. Unfortunately, such rewards sometimes motivate behavior not envisioned by top management. Both financial management and the auditors should be aware of those areas that are susceptible to manipulation for increasing bonus pay-outs. The internal control structure of the company must be strong enough to support the bonus program needs and cope with the pressures created by the program. It must be sufficient to produce timely, reliable data on which bonus program decisions are made.

Timely financial results are needed because bonus programs are most effective if there is a short time between accomplishing the objectives and paying the bonuses. Obviously, if the data is not reliable, bonuses paid will be inappropriate for the actual accomplishments.

The motivational aspect of bonus programs puts much pressure on the system. While obtaining an understanding of the internal control structure, auditors should bear in mind that there may be a temptation to manipulate data used for bonus determination. Auditors should be familiar with the bonus program, and should take its provisions into consideration when assessing control risk and in determining the nature, timing and extent of substantive tests.

There are myriad examples of irresponsible acts by otherwise rational managers due in large part to temptations to influence the calculations. One example, which demonstrates why the auditors must understand and consider the bonus program, occurred at a mid-western division of a major corporation. A new division manager was appointed to turn around the troubled division. In his first year he increased income dramatically. Based on the bonus formula, he and the division executives were paid exceptional bonuses for far exceeding bonus targets. Senior management was so pleased that they promoted him to group vice president. He hired a new division manager whose first quarter sales were significantly below target. Losses replaced profits. The group vice president discharged the new manager and took over the division himself until he could find a replacement.

This situation occurred when both the internal and external auditors had decided to skip the year-end audit of this division. A subsequent audit disclosed that many unshipped orders were booked as sales during the fourth quarter. This explained the exceptionally high sales and earnings for the past year, and the inability of the new manager to ship a sufficient quantity of products during the first quarter of the new year. The group vice president and division controller were discharged. Situations like this negatively impact the corporation and the lives of many people.

There are many instances when the accounting is geared to the bonus rather than to GAAP, but most are much more subtle. Usually they involve under-accruing expenses, delays in recording accounts payable, and underestimating doubtful accounts receivable or slow moving and obsolete inventory. In all of these cases, management and their auditors should keep in mind the bonus calculation as a reason to increase reported income.

The basic design issues for an annual bonus plan are: Who is eligible? How are individual potential bonus awards determined? And how will a units' performance be measured in determining the total bonus payable to the unit's participants?

Eligibility

Only those employees whose performance can significantly impact the company's results should be eligible for incentive bonuses. This is easier to say than put into practice. Most companies use one of three approaches in determining which employees are eligible for bonuses: key position, salary level, or salary grade. The choice of approach usually depends on the size of the company. Smaller companies will probably be able to use the key position approach, for which potential bottom-line impact is the criterion for selection. The necessity of reviewing the list of eligibles annually for appropriate additions and deletions may make this approach impractical for larger companies. Salary-level or salary-grade selections are easier for larger companies to administer, with salary grade having the advantage of relating to a position rather than an individual's salary. When using the salary level approach, it is necessary to adjust the cutoff annually to avoid continual increases in bonus eligibles. The problem inherent in this approach is the strong pressure to raise peoples' salaries to or above the "magic" cutoff.

Whatever approach is used, there will be pressure to expand the eligible list. Bonus eligibility represents status as well as an opportunity to earn more money and is therefore coveted by many employees. There should be a rationale for determining eligibility and a determination of how the eligibles list will be expanded and over what period. If too many people are eligible for bonuses, the individual awards will be less meaningful. The impact of the program may be lost.

Bonus calculations for operating divisions are based upon financial data provided by the division's chief accounting officer, who, as a key employee, is usually a bonus participant. This conflict of interest may be resolved by making the position ineligible for bonus participation and increasing the salary to be competitive with the same position in companies which do not pay bonuses.

Individual Bonus Awards

To achieve the desired objectives of the program, potential awards must be significant enough to motivate the bonus participants and be tied to the achievement of the company's objectives.

If the bonus is only a small percentage of salary, it is unlikely to provide a stimulus to extraordinary effort. In many companies, the normal bonus opportunity for an executive with significant responsibility is 40% to 50% of salary, with an opportunity to earn double that amount for achieving truly outstanding results. Such amounts generate powerful motivation.

The key management personnel who will participate in the program are determined for each operating unit prior to the beginning of each year. Based on their responsibilities, they are assigned a bonus percentage. Each participant's annual salary is multiplied by the bonus percentage to determine his or her potential bonus. This potential bonus, which is commonly referred to as a participant's "bogy," is the expected bonus to be earned if two things happen: The unit must attain its specified bonus objectives, and the participant must perform well. The sum of all the participants' "bogies" is the amount the firm plans to allocate to the bonus scheme and is usually referred to as the "bonus pool" for the operating unit. The relative size of the individual "bogies" to salaries determines the degree to which the program will drive performance and focus attention on the organization's goals.

Measuring Performance

An operating unit's formula for earning a bonus is usually based upon the degree of success in attaining unit goals, which are stated in terms of performance criteria--operating income, cash flow, return on investment, etc. Where bonus programs involve more than one operating unit, i.e., divisions and/or subsidiaries, separate formulas normally are tailored to the circumstances of each unit. Corporate bonuses may be based on a formula using overall company criteria, or may be based upon a judgement by the compensation committee of the board of directors. In developing bonus programs, care must be taken to assure that attainment of unit goals will consolidate into attainment of corporate goals.

The selection of appropriate criteria is crucial to the success of any incentive program. The criteria must reinforce organizational goals and encourage behavior that leads to accomplishment of these goals. The key performance criteria for judging an operating unit are used as the bonus targets. Senior management's judgment of the relative importance of each criterion will determine the weight given to it in the bonus calculations. These quantifiable targets comprise the "contractual" segment of the bonus and relate to short range goals. If these target amounts are attained for the year, the bonus participants are rewarded.

Bonus target ranges for each criterion selected to achieve corporate goals are established. The bottom of the range is the point at which no bonus is earned, and the top is the point at which full bonus is earned. In between, a partial bonus is earned.

It is wise to use more than a single criterion of performance for earning a bonus. While using one criterion is simpler, there is no performance reinforcement for other important factors.

Balancing Short- and Long-Term Objectives

Care should be taken to assure that short-term objectives, upon which the program is based, are consistent with the long-term objectives of the enterprise. If new products are essential to future success, but negatively impact current year's earnings and cash flow, some provision should be made in the plan to deal with this situation, e.g., basing a portion of the bonus upon new product development.

To provide for achievements that may not be quantifiable both short- and long-range goals, some portion of the unit's bonus (usually 20% to 30%) should be discretionary, based upon senior management's evaluation. For example, achieving operating income goals could be 70% of the bonus pool with 30% being discretionary, or operating income could be 40% with cash flow and discretionary each comprising 30%.

A carefully constructed bonus program will list some of the key areas that will be considered in making the judgment of how the discretionary portion is earned. For example, this list might include the successful introduction of a new product, penetration of a new market, reduction of employee turnover, sale of obsolete or slow moving inventory, etc.

If, in retrospect, the bonus targets are considered inequitable by senior management, the discretionary portion allows them some flexibility to make corrections without having to abrogate the targets.

Extraordinary Performance

In many programs, a provision is made for rewarding extraordinary performance if the top of the target range is exceeded. Extraordinary performance should be subject to critical scrutiny, as it is frequently not real. Sometimes the nature of the company also dictates the need for caution. An example occurred at a division manufacturing computerized production test equipment designed to specification for durable goods manufacturers. Each project carried a multi-million dollar price tag. Because the span between the start of production and the delivery of product often exceeded a year, the division used "percentage-of- completion" accounting. With a base salary of $150,000 and bonus percentage of 40%, the division president's bogey was $60,000. The division reported pre-tax profit far in excess of its bonus target, and the division president was awarded a bonus of $120,000. During the following year the division lost money because actual costs to complete jobs shipped during the year significantly exceeded estimated costs used in computing the previous year's income. The engineering estimates of percentage complete proved to be very optimistic in the "record" year, which resulted in excessive bonuses to the division president and some other executives, including the V.P. Finance and the V.P. Engineering. Management changes followed in the aftermath of this lack of integrity in the financial reports.

How Actual Individual Bonus Awards Are Determined

As quickly as feasible after year end, the actual results are compared to the bonus targets, and the bonus percentage earned by each operating unit and the corporate office is determined. The percentage earned is multiplied by the unit's bonus pool to determine the dollar amount of bonus earned by the unit. The manager of the operating unit is then informed of two facts by the individual to whom he or she reports:

* Total bonus dollars earned by the unit.

* The bonus dollars earned by the manager (including a discretionary portion based on the manager's performance).

The unit manager then recommends the distribution of the portion of the discretionary bonus available to the operating unit, based on the performance of the employees in the unit. These recommendations are given to the chief executive officer (CEO), who submits his or her recommendations for corporate and operating unit bonuses to the compensation committee of the board of directors. The compensation committee reviews these recommendations and decides on the appropriate bonus for the CEO.

Proper Administration to Maximize Effectiveness

CPAs in industry frequently take the lead role in administering bonus programs. They are heavily involved in the review, analysis, and critique of strategic plans and budgets and comparison of actual results to plans and budgets. This leads to their involvement in developing realistic bonus targets and calculating bonus payments earned, which are the crucial elements in administering a program. Specific aspects which deserve careful attention are discussed below.

Bonus Targets Should be Designed to Motivate Maximum Efforts. If targets are too high, they may be viewed as unattainable and become discouraging. If they are too low they may be viewed as "in the bag," and encourage a euphoric and possibly indolent attitude. The objective should be to set targets at what will be viewed as "an attainable stretch." Analysis of profit plans is crucial to managements' judgment of what constitutes an attainable stretch. Some managers cannot resist the temptation to build cushions into their plans, to increase the likelihood that they will attain or exceed their planned income. At the other extreme are managers who are overly optimistic about their unit's capabilities: they project net income they believe will impress top management but could be perceived by their key employees as unattainable. Such an unrealistic target could discourage rather than motivate the operating unit employees.

Targets Must be Clearly Understood. It is critical that bonus participants participate in the setting of bonus targets. Their views and suggestions should be given serious consideration. When their suggestions are rejected or modified, the reasons should be clearly communicated. Misunderstandings concerning the bonus targets create unproductive time spent in discussions and demoralized employees who believe that they are being treated unfairly. Problems are most likely to arise in a new program or in connection with a newly acquired company. In a new acquisition, the inclusion of allocated corporate office costs in the unit's income statement is frequently a sensitive issue.

Corporate allocations should be dealt with at the outset, and agreed upon, or they will surely cause ill will later. Most companies include allocated corporate office costs, including interest expense, in the budgeted and actual income statement, and thereby reduce net income. The primary argument in favor of allocating corporate overhead is that if it was not done, operating units would ignore these costs in pricing decisions. It would then be possible for all the units to have net income while the overall company sustains a loss.

Periodically Communicate the Outlook for bonuses. To maximize the motivational value of the program, the financial staff of each operating unit should periodically communicate the current outlook for annual bonuses to bonus participants. This is accomplished by comparing a forecast of the bonus criteria with the bonus targets. Using the forecasted percentage of bonus earned for the unit, each participant can forecast his or her bonus. A review of the key actions necessary to accomplish or exceed the forecast should be included in this periodic bonus update. This can be a very strong motivational tool, because the bonus participants have an identifiable personal stake in the accomplishment of these actions. Many companies include a bonus update in their regularly scheduled operating review.

Resolve Bonus Problems Early. One way to accomplish this is to periodically update the outlook for bonuses for each operating unit. Strong lines of communication are beneficial to both operating units and corporate staff. One of the benefits of a bonus update is early identification of problems which require action on the part of senior management. Anyone who has lived through a year-end closing knows this is not the best time to resolve sensitive problems. By identifying problems in the bonus program as the year unfolds, it is possible to take prompt action, minimizing damage. If the bonus criteria have not been clearly stated, they should be modified with the participation of unit and senior management.

If the operating units and corporate staff have been monitoring the program during the year, the calculation of bonuses should go smoothly. The type of problems most frequently encountered are assertions by the operating unit that there are circumstances which were unforeseen at the time targets were set. They believe that in the interest of fairness, the situation warrants special consideration in determining the bonuses, e.g., war, recession, earthquake etc. Another could be an act of top management, such as a strike the unit was told to take, or a law suit they were instructed to settle even though they were confident they would win. Making changes in a bonus program can be a dangerous practice and should be considered only in exceptional circumstances. Too much flexibility in adjusting targets may destroy the motivational value of the program.

In many cases, determining the impact of unforseen events can be an impossible task. For example, consider the effect of a strike on earnings. It requires an estimate of the sales lost due to the strike. Sales may be higher before the strike due to customer anticipation and higher after the strike due to customers needing to replenish depleted inventory. Some customers may have been lost to competitors. The futility of calculating the earnings impact becomes apparent.

Many problems can be resolved by the financial staff if they are given careful attention and full consideration. Other problems must be brought to senior management's attention. The perceptions of the operating unit management must be dealt with, whether or not the problems can be resolved. The program must be viewed as dealing fairly with the participants if it is to be effective. Accuracy and fairness in calculating the bonuses are largely the responsibility of the financial staff. It is important they identify the problems they can resolve, and those that need operating management's attention.

Pay Bonuses as Soon as Feasible. A bonus can represent a significant portion of a key employee's compensation. This serves the purpose of getting his or her attention, which is a double-edged sword. The focus of attention should be the future, but for many employees the current year is not their chief concern until the previous year's bonus is paid. Delays in paying bonuses may create apprehension and tension which are counterproductive. If bonuses for the prior year cannot be paid within the first month of the new year, some of the positive impact of the bonus program is lost.

Put it in Writing

It is important to commit the bonus program to writing, even if there are no legal requirements to do so. While Federal law does not require shareholder approval of incentive plans, some states and stock exchanges require it. The SEC requires disclosure of how a plan operates for officers and directors. A written program will help avoid misunderstandings and confusion, and will therefore benefit both the participants and administrators.

Intelligence and Sensitivity

An annual bonus program can be an effective motivational tool for accomplishing the goals of a commercial enterprise. The program must be perceived as fair and realistic and must be administered with intelligence and sensitivity. CPAs in industry play an important role in the development and implementation of bonus programs and have a unique opportunity to make valuable contributions to the success of their company. Auditors should become knowledgeable about their clients' bonus programs to get a clearer focus on the impact of the programs on their audit and to enable them to make appropriate worthwhile suggestions for improvement.

Frederick D. Heiman, CPA, is an Assistant Professor of Accounting at Adelphi University. Before teaching, Mr. Heiman spent most of his career in private industry as a financial officer.